With the exception of some companies caught up in the commodities boom, small-cap stock prices have dropped from a year ago, when they were looking expensive relative to their large-cap counterparts.

“Small-cap valuations are starting to get an edge, although it’s not significant yet,” says Martin Ferguson, manager of Mawer New Canada Fund at Calgary-based Mawer Investment Management Ltd.

But a recession in the U.S. could cause small-cap stock prices to tumble — and that is a risk. In that scenario, broadly based institutional portfolio managers would reduce their holdings in this riskier asset class, regardless of company fundamentals.

“In this environment, managers are looking for well-financed companies with strong balance sheets,” says Sebastien Van Berkom, president of Montreal-based Van Berkom & Associates Inc., “so that they will be insulated from the U.S. economic slowdown.”

Normally a late-cycle sector to avoid, industrials are favoured by many managers who see small-cap firms benefiting from government spending on infrastructure. “People want to put their money in companies tied to infrastructure spending,” says Ferguson. “The stock prices are starting to reflect that, but it will continue for the next three years.”

Ferguson is overweighted in industrials. He likes Canam Group Inc., a leader in steel manufacturing, and Lockerbie and Hole Inc., a building contractor, both of which are trading below discounted cash flow.

Van Berkom adds Genivar Income Fund to the mix because it builds roads and bridges in Quebec, as well as Toromont Industries Ltd., which builds construction equipment.

While money managers tend to be underweighted in financial services, they do like some niche businesses that are trading at low prices. Equitable Group Inc. and Home Capital Group Inc., both based in Toronto, are second-tier mortgage-financing companies whose stock prices have dropped as a result of the credit crunch. But they are strong lenders in the Canadian housing market, in which lending practices are tight compared with the U.S., Ferguson notes.

In the health-care sector, Van Berkom likes Ontario-based CML Health Care Income Fund, which does lab testing for biotech companies and other health-care services companies. It’s also a consolidator of radiology labs.

In the tech sector, Ferguson likes Logibec Groupe Infor-matique Ltee, a dominant IT provider for the health-care industry in Quebec. It recently bought a large competitor in the U.S. He also likes Constellation Software Inc., which develops similar software systems for government, transit systems and small industries.

Other small-cap tech plays include AutoModular Corp., which, Ferguson says, is attractively valued. It has long-term outsourcing contracts for assembly-line items for the Ontario auto industry.

Glenn Paradis, senior portfolio manager at AEGON Capital Management Inc. in Toronto, points to Absolute Software Corp., which develops laptop security for government and corporate clients.

As for consumer staples, Van Berkom likes Premium Brands Income Fund, which distributes packaged meats and sandwiches in Western Canada. Another play on the strength of the western economy is Glacier Ventures International Corp., the publisher that bought many of Hollinger Inc.’s assets. Van Berkom says management has proven it can realize stronger margins by consolidating businesses.

— GAVIN ADAMSON